When Moody’s Investors Service (MCO) downgraded Ireland’s sovereign debt to junk status on July 12, a week after giving Portugal’s debt similar treatment, it came as no surprise to Sandor Steverink. Europe’s best-performing government bond fund manager over the last decade, Steverink predicted both downgrades. Soon it will be time to buy, he says. “What we’ve learned from emerging markets is that you get only a full recovery after a proper restructuring,” says Steverink, who is co-head of a team managing €26 billion ($36.4 billion) at Dutch insurer Delta Lloyd. “We think that’s necessary for Greece and, in the end, probably for Ireland and Portugal, too.”

Of the two countries, “we prefer Ireland above Portugal,” he says, because Ireland’s debt burden was caused by the banks, not by “structural problems” such as heavy government borrowing and slow growth. He believes Ireland also has more potential to export its way out of trouble. Ina Goedhart, Steverink’s colleague, says the fund would wait at least a month before buying any Portuguese debt. Why? Many investors who can’t hold the bonds now that they have been downgraded to junk status will be forced to sell, pushing their prices down, says Goedhart.

Steverink’s Delta Lloyd Institutional Obligatie has returned 5.8 percent a year since 2001, making it Europe’s best-performing euro-denominated government bond fund with more than €500 million of assets over the past 10 years, according to Morningstar (MORN). It also beat all rivals over the past three and five years.

While Steverink hopes to profit from low-rated bonds rebounding, others are betting on price declines. Nick Swenson, who runs Groveland Capital in Minneapolis, has been speculating on sovereign defaults in peripheral European countries since March 2010. His $10 million fund is buying credit-default swaps on Spanish and Italian government bonds. CDS are a type of insurance that makes investors whole if a borrower fails to pay. Even without a default, their prices can rise when the bonds they are linked to fall in value. Swenson believes CDS on Spanish and Italian government bonds offer potential for profit because they are underpriced in light of the countries’ shaky finances. “People think they aren’t at risk of defaulting,” he says. “Prices of all non-Greek bonds seem to be too optimistic.”

Olivier De Larouzière, who manages Paris-based Natixis Asset Management’s Souverains Euro fund, is betting against medium-term Spanish bonds. The market’s view of Spain is “too positive, if you consider how systemically risky the country is,” says De Larouzière. “It will be much more difficult for the institutions to deal with a Spanish crisis.”

Some hedge funds are moving beyond a direct bet that sovereign debt values will tumble, targeting potential fallout in the corporate debt market and the banking industry. They are making investments that will pay off if heavily indebted nations such as Portugal, Spain, and Italy slash spending, slowing growth and reducing discretionary consumer outlays. “Our thesis is that the bad countries can make bad corporate debt,” says Simon Finch, head of credit trading at CQS UK, a London-based hedge fund that oversees $11 billion. Finch has been trading the debt of mobile-phone companies, which he expects to suffer. “If you crimp people’s spending, you’ll find that phone calls are surprisingly discretionary,” he says.

Marathon Asset Management, a $10 billion fund run by Bruce Richards, told clients in a mid-June presentation that it’s evaluating the purchase of portfolios of $1 billion or more of real estate and corporate loans from banks in Portugal, Ireland, Spain, the U.K., and Italy that will be forced to sell debt to raise capital. Marathon, based in New York, says it has already traded more than $1 billion worth of sovereign credit in the peripheral European countries this year, using both CDS and bonds.

The bottom line: As Europe struggles to resolve its debt crisis, some money managers are betting bonds will fall even further and economies will slow.